If you want to buy your dream property, you need a lot of money. The same applies to modernization and renovation work. Expenses can quickly reach amounts that you can no longer pay out of your own pocket. In this case, a real estate loan is a sensible option. The annuity loan is particularly common. What exactly is it? We provide you with tips on this type of financing.
What Is an Annuity Loan?
The annuity loan is perhaps the best-known form of real estate financing. It is a loan that is generally registered in the land register. This gives the bank security in the event that you can no longer make the repayments.
This form of financing is also known as an amortizing loan or repayment loan. It is a classic loan. But there is one special feature. You pay a fixed amount to the lender—usually the bank—every month. This has a significant impact on the course of repayment.
How Is the Loan Installment Composed?
The monthly loan burden typically remains the same over the term of the loan. This applies provided that you have agreed to a fixed interest rate for several years. This monthly amount consists of two components:
- Loan interest, which you pay for the provision of the loan.
- Repayment amounts, with which you repay the loan bit by bit.
Together, these result in an amount that, calculated annually, is referred to as the annuity. The loan interest is based on a percentage of the respective current total loan amount. An example from the low-interest-rate years of recent times is a high three percent charged as loan costs.
However, you do not only pay monthly interest on the money borrowed; you also repay the loan bit by bit. The difference between the total monthly amount payable and the interest due, in euros, is the repayment amount. This is available solely to reduce the outstanding debt.
Interest and repayment together form the annuity. The formula for the installment of an annuity loan is therefore:
Annuity = Interest rate + Repayment rate
With Constant Installments, the Proportions Change
Now comes the major advantage of the annuity loan: Since you only pay interest on the outstanding debt and repay part of the loan every month, if you make repayments, the share of interest payments in the monthly amount continuously decreases. This means that a little more of the total amount due remains each month for repayment. The development of interest and repayment therefore moves in opposite directions. In this way, you initially reduce the loan only slowly; however, reducing the outstanding debt gains considerable momentum over time.
Important: This applies to a fixed-rate period during which you agree a fixed interest rate with the lender for a period of, for example, ten or 15 years. In the case of variable interest rates, the share of the interest amount may fluctuate along with the interest rates. Therefore, you should generally only arrange annuity loans with a fixed-rate period. Otherwise, rising interest rates may prevent the repayment effect from taking hold, and you will not reduce the outstanding debt quickly enough.
Example of calculating an annuity loan
The interaction between interest and repayment is difficult to understand at first. An example shows you how even the first few months bring about a change.
Assume that you buy a house and, after using your equity, need a remaining loan of 250,000 euros. Your bank grants you this loan as an annuity loan, and you also have the interest rate fixed for ten years. This is three percent. Since you earn well and want to repay the loan quickly, you start with a repayment rate of three percent as well.
Your initial interest burden in the first month amounts to 625 euros (250,000 euros x 0.03/12). Your desired repayment amount is also 625 euros. Your monthly instalment is therefore 1,250 euros. This so-called debt service remains the same every month.
Calculate it: In the first month, you repay 625 euros. An outstanding debt of 249,375 euros remains. With the same monthly burden, you now pay only 623.44 euros in interest, while the repayment share rises to 626.56 euros. This means that there is already a small change after one month. In the following month, the outstanding debt is only 248,748.44 euros. The interest share has already fallen to 621.87 euros. The repayment share correspondingly rises to 628.13 euros.
This can also be determined in annual totals. To do so, use the annual totals for interest, repayment and remaining loan from the example above in simplified form.
| Year | Annuity/year | Interest/year | Repayment/year | Remaining loan |
|---|---|---|---|---|
| 1 | 15,000.00 euros | 7,500.00 euros | 7,500.00 euros | 242,500.00 euros |
| 2 | 15,000.00 euros | 7,275.00 euros | 7,725.00 euros | 234,775.00 euros |
| 3 | 15,000.00 euros | 7,043.25 euros | 7,956.75 euros | 226,818.25 euros |
| 4 | 15,000.00 euros | 6,804.55 euros | 8,195.45 euros | 218,622.80 euros |
| 5 | 15,000.00 euros | 6,558.68 euros | 8,441.32 euros | 210,181.48 euros |
After five years, the initial parity between interest and repayment has already developed into a gap of almost 2,000 euros in favor of repayment. At the same time, you have already paid off just under 40,000 euros.
The repayment portion should be as large as possible
Experience shows that with low interest rates and a sufficiently large repayment amount, at least around one quarter of the loan amount can be paid off in the first ten years. The more you repay each month, the faster the remaining loan amount is reduced.
If, on the other hand, you are forced to set the initial repayment portion very low, you will still be left with an enormous debt burden after ten years. Extreme example: If you made no repayments at all, you would pay interest month after month, but the loan amount would remain the same. You would reduce nothing.
The annuity loan is therefore only advantageous for you if you can repay a significant amount from the outset. This works very well in a low-interest environment such as that of recent years. Regardless of income, the interest portion is comparatively low. Rising interest rates mean a higher interest burden and lower repayment with the same income. You will repay the loan for longer.
Variants are possible
The annuity loan is the most common real estate loan in Germany. If you need a loan for your property or to purchase real estate, the bank will generally suggest this loan to you.
However, there are various variants. The basic system remains the same in each case, but some components change. These include:
- Fixed-interest agreement: The term for fixed interest rates may vary. Ten or 15 years are typical. In an environment of rising interest rates, a longer fixed-interest period tends to be worthwhile. However, this drives up the interest rate, as banks include a risk premium. In addition, a long fixed-interest period can be disadvantageous if lending rates fall. Important for you: The German Civil Code grants you a special right of termination after ten years, even if you have agreed to a longer fixed-interest period. One disadvantage is that you the loan burden generally cannot be paid off within the term. Therefore, you need follow-up financing, for which the market environment can only be estimated very roughly.
- Forward loan: In combination with a fixed interest period, you can agree on a forward loan with your bank. This is a loan agreed at fixed terms and conditions that you only draw down in the future. This form of financing only makes sense in combination with other forms of loans or for modernization work planned for the future.
- Possibilities for special repayments: If you are granted the possibility of making special repayments, your interest rate will generally increase by a few tenths of a percentage point. However, whenever you have enough capital left over, you can make additional payments that directly reduce the remaining debt. This causes the loan amount to decrease more quickly. This approach offers you greater flexibility and security.
- Flexible interest rates: Even with a fixed interest period, you can agree on an interest-rate corridor with your bank. In this case, the actual interest rate rises and falls on the one hand with the base rate (usually with the Euribor). On the other hand, you have a fixed upper and lower limit that the interest rate does not cross. You should primarily agree on these corridors in combination with possibilities for special repayments.
- Fully amortizing loan: In some cases, it may make sense to agree on a fully amortizing loan. In this case, the end of the fixed interest period is linked to final repayment in full. If, for example, you have invested a fixed amount of capital for the long term that will become available in a few years, this allows you to plan effectively. However, you should only choose this option if the money is certain to be available. If you cannot pay the final amount, a forced sale may be threatened. The only alternative is follow-up financing.
- Early repayment: If you have sufficient funds available, you can repay loan burdens in full early. However, the banks charge an early repayment penalty, which must be paid in addition. This is generally lower than the interest burden incurred through continued repayment. You effectively save money.
- Non-genuine annuity: From time to time, banks may offer you a non-genuine annuity. In this case, the interest rate decreases as usual, but the repayment portion remains constant. This means: The monthly installment decreases constantly. The disadvantage is a longer Term, as the repayment amount does not increase as it does with a genuine annuity loan.
Factors influencing the interest rate
Like any loan, the annuity loan is based on an interest rate. This depends not only on the current construction interest rate/mortgage interest rate. Rather, your personal creditworthiness and the property you want also play a role.
Please note that you can reduce the interest rate significantly in some cases if you have excellent creditworthiness and can provide collateral beyond the property itself – for example, additional properties, endowment life insurance policies or other assets. On the other hand, benefits such as the option of making unscheduled repayments or fixed interest periods are usually obtained through surcharges.
Tip: Do not speak only with your own bank. Engage a free loan broker. They will obtain offers and compare the terms for you. This makes it easier to find a particularly attractive loan.
Your most important security is the property. The bank will have the loan liability registered in the land register. If payments are not made, this gives it the option of selling the property and using the proceeds to repay the loan.
Experience shows that, with the same creditworthiness and similar collateral, you will receive a particularly favorable interest rate if you can contribute 40 percent of the total property purchase price from your own funds. If you need significantly less money than a 60-percent financing arrangement, the interest rate will no longer fall noticeably. The minimum equity should be ten to 15 percent of the total amount, including ancillary costs. Full financing is possible, but represents a risk for the bank, and the interest rate rises significantly. You will then hardly be able to obtain an annuity loan for your dream property.